The HSH Two-Month Mortgage Rate Forecast

December 28, 2018

Preface With the Fed no longer providing overt verbal policy guidance to investors, things have become a little rocky in financial markets over the last couple of months. Moving monetary policy closer to normal was never going to be a simple, easy or painless process, but it is a necessary one, and historically, interest rates are still low and stimulative, with "real" rates just above zero for the first time in many years. The problem is, many of today's investors and decision makers have little experience operating in a rising interest rate climate, let alone one devoid of a Fed shining a flashlight beam into the darkness ahead.

We can remember a time when the Fed didn't tell markets anything at all; moves had to be sussed out of clues and subtle signals. Today, we have quarterly projections, routine press conferences discussing policy actions (or inaction) and minutes of meetings are released just a few weeks after the close of a policy get-together, plus plenty of speeches and more. All add to the noise and probably to the confusion, too; even the Fed chair himself hasn't exactly been clear. Just prior to the last forecast, Jay Powell proffered that the federal funds rate was "a long way from neutral, probably" only to subsequently walk back that comment in late November, with a quote suggesting that rates were "just below" a level some consider neutral.

A period of slower economic growth in developed economies and the prospect of more slowing of domestic and global growth ahead has quelled appetite for riskier assets (i.e. stocks, certain bonds), making markets a wild ride. This in turn has sent investors to the safe harbors of U.S. Treasuries and other sovereign bonds, with the surge in demand beating down only recently-risen yields by a fair bit (and even causing a partial inversion of the Treasury yield curve for a time).

At our last forecast, the Fed had just reached the final station in its plan to run off investments held on its balance sheet. The process was well described in advance, is a gradual and protracted process and should cause little concern or impinge on market liquidity. So far, so good, even if some seem to think that a gradual drain of cash pumped into the economy is troublesome. Some observers have speculated that the Fed should continue to use its balance sheet as a monetary policy support, but since this remains an untested method, the Fed has expressed a preference to use more traditional policy levers, and the deleveraging process for now remains on "autopilot".

That said, we may be nearing the end of interest rate increases for this cycle, with perhaps only one or two more to come in the next year. To the extent that current levels of rates are mildly restrictive (it is an open debate at the moment if they are) any subsequent increases will be more so. To keep the Fed at bay, GDP growth will need to settle back into the low-to-mid 2% range, employment growth will need to ease back to what is believed to be a more sustainable level, and inflation will need to remain near the Fed's 2% speed limit.

So markets find themselves in a rough patch of reassessment. How much risk to hold? How much safety? How should investment strategies be shifted as central banks look to unwind emergency-era policies and begin (or continue) a trek toward normal?

Recap It's not often that we'd say that we're happy that our last forecast turned out to miss the marks we set. However, we're of course glad for potential mortgage borrowers that mortgage rates reversed course to a degree late in our forecast, ending the period at levels last seen in summer 2018. For the November-December period, we thought we'd generally see firmer rates, with our expectation of a range for the conforming 30-year FRM of 4.74% to 5.08%, but the market presented us with a 4.55% to 4.94% spread instead. For 5/1 ARMs, we expected to see 4.07% and 4.33% boundaries, but the 3.98% to 4.14% span was what came. For the most part of the period, our forecast ranges were on target, but difficult stock markets, collapsing oil prices and the government shutdown all weighed on interest rates in the closing weeks of it.

As well, in the midst of the last forecast, we had a mid-term election that resulted in the House of Representatives changing hands, arguably adding to the changing outlook for the U.S. business climate and perhaps unnerving markets a bit more.

Forecast Discussion Deep into the second longest economic expansion in U.S. history, and still in the midst of perhaps its strongest period of growth, a general sense of unease seems to have set in to financial markets. Whether or not there are spillover effects into the broad economy remains to be seen; so far, the important drivers of the economy remain positive, if somewhat less so. Housing is only creeping along (lower mortgage rates may help a little there) and manufacturing is slowing given uncertainties regarding trade, tariffs and the strength of trading partner economies, some of which have cooled considerably in the last couple of quarters. Consumer spending and optimism seem solid enough, if perhaps lessened a little of late.

Questions abound, and answers are few or murky at best. How can the Fed continue to raise interest rates when inflation has only barely made it to desired levels? With Japan still all-in in terms of stimulus, Germany stalling, and with growth in China drifting lower? How can the ECB be starting the process of ending QE-style programs with growth flagging and inflation dropping below ECB targets? What about the effects of the Brexit mess, no more settled that it has been, with the divorce deadline approaching in March? What are the effects of the ECB discontinuing outright purchases of bonds but following the path of the Fed, entering a extended period of reinvestment of maturing bonds? Will global sluggishness eventually drag down growth in the U.S., and if so, how soon? How will the fractious political climate change given the now-split legislative chambers, and is political gridlock the best we can hope for?

Amid these questions, conflicting messages and policy signals from the Fed are only adding to the noise, confounding the markets. To be fair, few if any of these things would be more settled even if the Fed was providing direct forward guidance.

The first time a new bicycle rider gives it a go without the training wheels is an unsteady, wobbly process, but with a little time, some distance and perhaps a bit more speed, the process becomes more comfortable amid growing confidence that those supports aren't needed. It seems to us that this is where we find markets at the cusp of 2019, in a very wobbly state, with economies and markets trying to maintain both balance and forward momentum without help. For the moment, odds favor that they will, but what's less clear is whether they will during the coming forecast period.

Even if such a thing existed, we don't need instant clarity in terms of where monetary policy will go; in fact, it's a fair bet that the Fed itself doesn't even know. We don't need a resurgent stock market powering to new record highs, or re-firming oil prices. We don't need to know exact outcomes for Brexit, or whether China, Germany and Japan will see growth picking up.

At the moment, we simply need something positive to hang our hat on to provide a basis for forward optimism. Getting the U.S. government stalemate resolved would be a start. From there, we'll then need a growing bit of confidence by investors that they're okay on their own, that growth cooling to long-run sustainable levels is a good thing (and less likely to bring aggressive Fed policy into play), and that oil's downward influence on inflation (not even fully realized just yet) will pass and prices will re-firm over time.

Whether we get some, all or none of these things or not in the next nine weeks remains unclear. Even without, markets over time can generally become accustomed to anything -- even chaos -- so some modicum of stability does seem possible. It is this we are hoping for and expecting in the period just ahead.

Forecast Making predictions for the future path of mortgage rates (any market, really) is rarely without hazard, but at a time when rationality seems to have taken a holiday from the markets it is especially challenging. Not four months ago, investors were confident despite an active Fed, a fractious political climate and impending elections; now, they seem tenuous, even fearful, even though there has not been all that much change to policy or politics. Slowing global growth is real, though, as is the effect on inflation and interest rates from rock-bottom oil prices and trade and tariff disputes. Those effects should have quelled rising rates and pulled them back down a bit a bit, but not to the extent we have seen.

We're starting 2019 at a point for mortgage rates rather lower than expected; this doesn't mean that there is no chance they can move lower still, but probably does suggest a greater chance for an upside breakout if the economic and political climate brightens during the period. Uncertainty being what it is, we've adjusted our ranges down rather considerably for the next nine-week period, when we expect to see the average offered rate for a conforming 30-year FRM as tallied by Freddie Mac to hold a range between 4.40% and 4.80%. With the recent decline in rates, it's a fair bet that fewer borrowers will be interested in ARMs, but rates there will also be a little lower, and the average initial rate for a conforming hybrid 5/1 ARM will probably manage to remain between 3.85% and 4.15% over the forecast period.

This forecast expires on March 1. Will our expectations be accompanied by the soft promise of spring, or will the hard uncertainty of winter's markets still be with us? Drop back in and see.

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If you're of a mind to, there's also our yearlong 2019 Outlook to peruse.